How Fed Fights or Encourages Inflation

 

When Paul Volcker fought inflation, the way he did it was letting interest rates go higher than the inflation rate.   The graph below has 10 year interest rate (blue), the inflation rate (red), and then the difference between these (green).   When the green line was far below zero Volcker was fighting inflation hard.

However, when the green line is near zero or above zero, the Fed is encouraging inflation.   In the 1970s the green line was near zero or spiking above zero.  This was encouraged the inflation of the 70s. 

As Milton Friedman taught, inflation is always and everywhere a monetary phenomenon, but there are long and variable delays between Fed policy inputs and the inflation result.   It can take years for inflation to show up, or go away, after a Fed policy change. 

For the last few years the green line has been near zero and above, similar to the 1970s.   Having interest rates below the inflation rate is once again encouraging inflation.    Inflation is starting to show in measures like the CPI.

Intuitively this makes sense.   If it is possible to borrow money at rates below the inflation rate then lots of companies and people are going to borrow money, which will cause the banks/fed to increase the money supply, which will cause more inflation. 

Debt to GDP

 If we add up government debt, corporate debt, and household debt and divide by GPD we get a the following graph:

The total debt/GDP ratio is almost 3 times what it was in 1980.   In 1980 it was possible to survive with high interest rates but today high interest rates with these high debt levels would be horrible. 

 

 

Last Call for Punch Bowl?

 

The grey areas in the graph below are recessions.  Note how whenever inflation is above 3% and going up fast it suddenly goes down and there is a recession?   The Fed has to take away the punch bowl as part of its mandate is to control inflation.  When it does this there is a recession.   Note we are above 3% and going up fast.   People think the Fed can keep the same easy money policy for the next two years.  Inflation would be way too high if they do that.  This should be last call for the punch bowl.

 

Fred Graph of CPI:

 You can also see this in a graph of the PPI:

These two graphs make it look like there should soon be a recession.

However, this time it may not be possible to take away the punch bowl.   The Federal government is spending twice what they get in taxes and has huge debt.  They need the Fed to keep buying their bonds and to keep interest rates low.  If not for the Fed the interest rates would be much higher.  If interest rates on the debt were 5% it would take about half the taxes just to pay the interest.  In this case the Federal spending would be about 4 times the income left after paying interest.    They would be clearly insolvent and nobody would want to buy their bonds.  They really need the Fed to keep buying.   But if the Fed keeps buying then inflation will get out of control.   Probably inflation will get out of control.

It is strange that people can see the government making trillions of new dollars and then be surprised when inflation comes.   If you survey your friends, I bet your Libertarian friends are less surprised than your Democrat friends.

Shortages and Supply Chain Problems

First, the money creation is much faster than normal as seen in this M1 Money Stock graph.  Does not seem transitory.

 

If banks pays no interest on money and the prices of things are going up fast, it is  rational to buy stuff needed ahead of time, before prices go up further.  In these conditions, storing real goods is better than storing cash.   Of course this only works for things that you can store for some period of time.   So diapers, cans of tuna, cement blocks, and computer chips, work well, but not bananas.

Personal Consumption Expenditures: Durable Goods

 

 

When money is no longer a good store of value, it is better to store extra value in extra physical things that you know you will use eventually.   This is called a flight into real goods (Flucht in die Sachwerte) or crack-up boom.  It is part of "how fiat dies".  We are probably seeing some of this now.

Misses put it well long ago:

 

Once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. 

 

You have to look at it from a Game Theory point of view.  The government is printing way too much money.  The value of the money is dropping.  So each player is better off holding real goods than money.   So as each player has extra money, they buy extra stuff, even if they don't need it right away.   Also, if there are shortages and they might not be able to get all they want in the future it is better to order extra stuff now.

If people spend their extra money right away, this has the effect of increasing the velocity of money.   From the Equation of Exchange, we can see that increasing the velocity of money makes prices go up even more. 

You can also see it as an increased demand with no matching increase in supply, so prices should go up.   The supply was enough for regular use but not enough for goods to be used as a store of value.  So it can show up as "shortages".

If many people are ordering extra real good we could expect to see increased demand for shipping.  Sure enough, there is:

Drewry’s composite World Container index:

The above container price index does not look like a "transitory" problem.

Politicians will try to divert blame for the inflation from their money printing to "hoarding" or "panic buying".  The only reason people are buying extra stuff is that the prices are going up fast.  If the government/central-bank stopped printing money the prices would stop going up fast.   The hoarding is a symptom of the inflation (and part of the natural process) and not the core cause of the inflation.

That money is no longer a good store of value is probably the core problem causing the "shortages" and "supply chain" problems.  In the coming months it will become more clear if this is in fact what is going on. 

Transitory Hyperinflation

 

 

 Bank of America is reported to have said:

On an absolute basis, [inflation] mentions skyrocketed to near record highs from 2011, pointing to at the very least, “transitory” hyper-inflation ahead.

 

The article also says:

      Because if there is one thing hyperinflation is, it's "transitory."

 

This was in a phone call and probably B of A wanted to say "high inflation" and not "hyper-inflation".  However, this could be a freudian slip, showing what they really think.

 

Normal money is both a store of value and a medium of exchange. Hyperinflation is the transitional stage where a money no longer acts as a good store of value but it is so far still being used as a medium of exchange.  Eventually it fails as a medium of exchange also,  and is no longer money.   So fundamentally hyperinflation is the transition period between half dead money and dead money.  It is the process of "How fiat dies".   So as the article says, "if there is one thing hyperinflation is, it's transitory".  :-)